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Alibaba Investors Will Buy a Risky Corporate Structure

By Steven Davidoff Solomon May 6, 2014 7:46 pmMay 6, 2014 7:46 pm

Photo

Credit Harry Campbell

Shareholders have been willing to take a lot of risk in their lust for Internet initial public offerings, but Alibaba’s I.P.O. may take that risk to a whole new level. The reason: Investors in the offering won’t have title to most of Alibaba’s Chinese assets because of Chinese prohibitions on foreign ownership.

What exactly will shareholders be buying, you may be asking. In Tuesday’s securities filing, Alibaba revealed the answer.

The Chinese e-commerce behemoth will wholly own its non-Chinese assets, which provide the bulk of its revenue, according to the filing. Alibaba will not own most of its Chinese assets, including Taobao Marketplace and Alibaba.com. So the companies that are the core of Alibaba’s Chinese operations — the main reason for the anticipated heated investor demand — will not even be owned by Alibaba.

Instead, the company is using a so-called variable interest entity structure. It works for Jack Ma, Alibaba’s co-founder and executive chairman, but whether it works for investors remains to be seen. The reason is that for Alibaba’s investors, a V.I.E. is chock-full of risk, which they may ignore as they salivate over potential Internet riches.

What is the V.I.E. structure, you may be asking.

The structure was created in 2000 to circumvent Chinese restrictions on investment in certain industries, like technology and communications. It is now the favorite way for companies to list in the United States. Renren and Baidu, for example, are variable interest entities.

Alibaba is using a straightforward V.I.E. structure for its Chinese assets. Investors in the United States offering will not be buying shares in Alibaba China. Instead, they will purchase shares in a Cayman Islands entity named Alibaba Group Holding Limited.

Most of Alibaba’s Chinese assets will be owned by Mr. Ma and another founder and member of management, Simon Xie. The Cayman Islands company has contractual rights to the profits of Alibaba China, but it has no economic interest.

If it all sounds too neat, there are two significant risks with the V.I.E. structure — risks that Alibaba has bluntly acknowledged.

The structure may be illegal under Chinese law since it conveniently circumvents those prohibitions on foreign investment.

There is precedent for such a finding.

In a letter to Baidu questioning the effectiveness of such a structure, the Securities and Exchange Commission noted that a ruling in late 2012 by the Supreme People’s Court of China invalidated a V.I.E. structure used by Minsheng Bank.

Baidu responded that Minsheng Bank was different and had not used a normal V.I.E. Specifically, that structure gave the true owners of Minsheng too much control over voting.

Even if Minsheng is different, it highlights that the V.I.E. structure is of uncertain legality in China.

At least one locality has declared the structure illegal, and in a 2011 decision, the Chinese merger control authority stopped Walmart from using a V.I.E. to acquire a controlling stake in Yihaodian, a leading online Chinese retail business.

More telling, the V.I.E. structure replaced another work-around joint-venture structure that was first used by China Unicom in 1994. But four years later, that structure was declared illegal by the Chinese government, which forced the company to unwind it. The same thing that happened to China Unicom could happen to Alibaba.

Alibaba has attempted to address this risk by getting a legal opinion that the V.I.E. structure is kosher. However, Alibaba, in its filing, also states that the law firm giving the opinion acknowledges that “there are substantial uncertainties regarding the interpretation and application of current and future PRC laws, rules and regulations.” Thus, even Alibaba’s legal opinion, designed to comfort shareholders, hedges its bets by saying it could be wrong. Some comfort.

Many argue that while there is risk, it would be too harmful to the Chinese economy if China were to declare the V.I.E. structure illegal. But beyond the risk of legality, such a structure means that if shareholders in the United States want to enforce their rights, they will have to do so based on contracts between a Cayman Islands entity and one based in mainland China.

And these contracts will have to be enforced through the Chinese legal system. Historically, it has been difficult or impossible for Americans to enforce contractual rights in China if they were not set there. This leaves shareholders at the mercy of whoever holds the assets of the Chinese company.

Previous problems with the V.I.E. structure illustrate this. A number of Chinese companies listed in the United States using the structure have lost control of their Chinese-based arms. In 2008, the Agria Corporation lost control of its Chinese subsidiary to a disgruntled executive. The company got back its assets only when the executive was paid additional compensation.

Because the Chinese assets are often held by the chief executive or founder, a dispute with that executive can be fatal for the company. In the case of the Chinese education company ChinaCast, insurgent American shareholders took over the board of the United States-listed company. But the shareholders were left with nothing when the old ChinaCast executives simply transferred the company’s assets to themselves.

If that were not enough, the issue has come up with Alibaba. In 2011, Yahoo and Alibaba got into a dispute when, without Yahoo’s permission, Mr. Ma transferred Alipay, Alibaba’s online payment subsidiary, to a company that he owned. The issue was resolved with Mr. Ma retaining ownership of Alipay and the company agreeing to make payments to Alibaba.

In other words, American investors will be at the mercy of Mr. Ma and Mr. Xie, the holders of the Chinese assets of Alibaba. Mr. Ma was adamant that Alibaba list with a structure that kept voting control with him, but he has gone to extremes. He is singular in retaining ownership of Alibaba’s assets with Mr. Xie.

The S.E.C. cannot ban offerings for being “too risky” or even for potentially being illegal. The only thing the regulator can do is require disclosure of the risks. It has done so here: Alibaba, in its prospectus, states that if the V.I.E. structure is ruled illegal, then Alibaba’s business may be significantly harmed and substantial fines might be imposed.

In addition, the Internet company acknowledges that the V.I.E. structure may “not be as effective in providing control … as direct ownership.” You need only ask ChinaCast’s shareholders what that can mean.

The New York Stock Exchange or Nasdaq — wherever Alibaba will choose to list — can refuse to accept the Chinese company on the grounds that it is too risky, and the underwriters can also say no.

But they appear to be fine with this risk, preferring to collect their fees and perhaps leaving American shareholders holding the bag if things go wrong.

As investors contemplate putting billions into Alibaba, they may want to actually consider what that money is buying.